Chapter 19

Theory of Consumer Behavior

Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

19-1

Chapter Objectives
Marginal utility The law of diminishing returns Total utility Maximizing utility The water-diamond paradox Consumer surplus

Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

19-2

Utility
What is utility?
Utility is NOT usefulness! Utility means only that you think enough of something to buy it Utility is measured by how much you are willing to pay for something

Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

19-3

Hypothetical Demand Schedule for Hamburgers

Price $2.75 Units Purchased 1

Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

19-4

Hypothetical Demand Schedule for Hamburgers

Price $2.75 2.00 Units Purchased 1 2

Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

19-5

Hypothetical Demand Schedule for Hamburgers

Price $2.75 2.00 1.00 Units Purchased 1 2 3

Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

19-6

Hypothetical Demand Schedule for Hamburgers

Price $2.75 2.00 1.00 .25 Units Purchased 1 2 3 4
19-7

Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

Marginal Utility is the additional utility derived

from consuming one more unit of a good or service

Price $2.75 2.00 1.00 .25

Units Purchased 1 2 3 4

MU $2.75 2.00 1.00 .25

19-8

Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

Marginal Utility is the additional utility derived

from consuming one more unit of a good or service

Price $2.75 2.00 1.00 .25

Purchased 1 2 3 4

MU $2.75 2.00 1.00 .25

19-9

Note: Marginal Utility is the same as the price.

Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

Law of Diminishing Marginal Utility: As we consume more and more of a good or service,we like it less and less

Price $2.75 2.00 1.00 .25

Units Purchased 1 2 3 4

MU $2.75 2.00 1.00 .25

19-10

Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

Total Utility is the utility derived from consuming

a certain number of units of a good or service

Price $2.75 2.00 1.00 .25

Units Purchased 1 2 3 4

MU $2.75 2.00 1.00 .25

TU $2.75

Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

19-11

Total Utility is the utility derived from consuming

a certain number of units of a good or service

Price $2.75 2.00 1.00 .25

Units Purchased 1 2 3 4

MU $2.75 2.00 1.00 .25

TU $2.75 4.75

Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

19-12

Total Utility is the utility derived from consuming

a certain number of units of a good or service

Price $2.75 2.00 1.00 .25

Units Purchased 1 2 3 4

MU $2.75 2.00 1.00 .25

TU $2.75 4.75 5.75

Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

19-13

Total Utility is the utility derived from consuming

a certain number of units of a good or service

Price $2.75 2.00 1.00 .25

Units Purchased 1 2 3 4

MU $2.75 2.00 1.00 .25

TU $2.75 4.75 5.75 6.00

19-14

Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

Total Utility is the utility derived from consuming

a certain number of units of a good or service
Units Price Purchased $2.75 1 2.00 2 1.00 3 .25 4 MU $2.75 2.00 1.00 .25 TU $2.75 4.75 5.75 6.00

To get total utility, just add up the marginal utilities of the units purchased
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

19-15

Maximizing Utility
How much we buy of any good or service depends on
Its price Our marginal utility schedule
Price $2.75 2.00 1.00 .25 Units Purchased 1 2 3 4 MU $2.75 2.00 1.00 .25 TU $2.75 4.75 5.75 6.00

In real life there is usually only ONE price!

Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

19-16

Maximizing Utility
We try to spend our money on what will give us the most utility!
As we consume more of a good or service, its utility declines! This means that we will keep buying more of a good or service until our marginal utility falls to the

level of the price. At this point marginal utility is the same as the price.

Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

19-17

Maximizing Utility
We try to spend our money on what will give us the most utility!
As we consume more of a good or service, its utility declines! This means that we will keep buying more of a good or service until our marginal utility falls to the

level of the price. At this point marginal utility is the same as the price.
Marginal Utility Price = 1

Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

19-18

Maximizing Utility
We try to spend our money on what will give us the most utility!
Remember, as we consume more of a good or service, its utility declines! This means that we will keep buying more of a good or service until our MU falls to the level of the

price
Price $2.75 2.00 1.00 .25

The price is $1.00. How many units would you buy? Units Purchased 1 2 3 4 MU $2.75 2.00 1.00 .25 TU $2.75 4.75 5.75 6.00

The answer is 3

Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

19-19

Maximizing Utility
We try to spend our money on what will give us the most utility!
Remember, as we consume more of a good or service, its utility declines! This means that we will keep buying more of a good or service until our MU falls to the level of the

price
The MU of the last unit purchased will always equal its price Price $2.75 2.00 1.00 .25 Units Purchased 1 2 3 4 MU $2.75 2.00 1.00 .25 TU $2.75 4.75 5.75 6.00

The answer is 3

Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

19-20

Maximizing Utility
We try to spend our money on what will give us the most utility!
Remember, as we consume more of a good or service, its utility declines! This means that we will keep buying more of a good or service until our MU falls to the level of the

price
The price is $2. How many units will you buy? Price $2.75 2.00 1.00 .25 Units Purchased 1 2 3 4 MU $2.75 2.00 1.00 .25 TU $2.75 4.75 5.75 6.00

The answer is 2

Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

19-21

Maximizing Utility
We try to spend our money on what will give us the most utility!
Remember, as we consume more of a good or service, its utility declines! This means that we will keep buying more of a good or service until our MU falls to the level of the

price
Price $2.75 2.00 1.00 .25

The MU of the last unit purchased will always equal its price Units Purchased 1 2 3 4 MU $2.75 2.00 1.00 .25 TU $2.75 4.75 5.75 6.00

The answer is 2

Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

19-22

General Utility Formula

The MU of the last unit purchased will always equal its price
MU 2.75 = = Price 2.75 2.00 = 2.00 1.00 1.00 = .25 .25 = 1

If this is true for hamburgers it will be true for everything else MU1 MU2 MU3 MUn = = = Pn P3 P2 P1 Remember, we will keep buying anything until its MU declines to the price level
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

19-23

Price $2.75 2.00 1.00 .25 0

Purchased 1 2 3 4 0

MU $2.75 2.00 1.00 .25 0

TU $2.75 4.75 5.75 6.00 6.00

If a good or service were free, you would keep consuming until the MU fell to zero As we consume more units, MU declines, but TU keeps rising Therefore, we maximize our total utility when our MU falls to zero
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

19-24

Hamburgers Price $ 3.00 2.00 1.00 QD MU 1 $3.00 2 3 2.00 1.00

Fries Price QD MU $1.50 1.00 .50 1 2 3 $1.50 1.00 .50 $1.50 .50

Coke Price OD MU 1 $1.50 2 .50

How many burgers, fries, and cokes would you consume if burgers were $3, fries were $.50 and cokes were $.50?

Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

19-25

Hamburgers Price $ 3.00 2.00 1.00 QD MU 1 $3.00 2 3 2.00 1.00 $1.50 1.00 .50

Fries Price QD MU 1 2 3 $1.50 1.00 .50 $1.50 .50

Coke Price OD MU 1 $1.50 2 .50

How many burgers, fries, and cokes would you consume if burgers were $3, fries were $.50 and cokes were $.50?

One hamburger; three fries; and two cokes

Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

19-26

Hamburgers Price $ 3.00 2.00 1.00 QD MU 1 $3.00 2 3 2.00 1.00 $1.50 1.00 .50

Fries Price QD MU 1 2 3 $1.50 1.00 .50 $1.50 .50

Coke Price OD MU 1 $1.50 2 .50

How many burgers, fries, and cokes would you consume if burgers were $1, fries were $1.00 and cokes were $1.50?

Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

19-27

Hamburgers Price $ 3.00 2.00 1.00 QD MU 1 $3.00 2 3 2.00 1.00 $1.50 1.00 .50

Fries Price QD MU 1 2 3 $1.50 1.00 .50 $1.50 .50

Coke Price OD MU 1 $1.50 2 .50

How many burgers, fries, and cokes would you consume if burgers were $1, fries were $1.00 and cokes were $1.50? First answer: one hamburger; three fries; and two cokes Second answer: three hamburgers; two fries; one coke This is consistent with the law of supply and demand
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

19-28

The Water-Diamond Paradox

Water, which is essential to life is cheap
Water is abundant A great deal of water is consumed
Therefore the MU of the last gallon consumed is as low as its price, which is relatively low

Diamonds are not essential to life, yet they are very expensive
Diamonds are scarce People buy relatively few diamonds
Therefore the MU of the last diamond purchased is as high as its price, which is relatively very high

Muwater MUdiamonds = 1 = Pdiamonds Pwater

Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

19-29

Consumer Surplus
Consumer surplus is . . . the difference between what you pay for some good or service and what you would have been willing to pay Price Purchased MU TU
$2.75 1 2 3 4 5 $2.75 2.00 1.00 .25 0 $2.75 4.75 5.75 6.00

Hamburger Schedule

2.00 1.00 .25 0

The price of hamburgers is $0.25

Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

19-30

Consumer Surplus
Consumer surplus is . . . the difference between what you pay for some good or service and what you would have been willing to pay Price Purchased MU TU
$2.75 1 2 3 4 5 $2.75 2.00 1.00 .25 0 $2.75 4.75 5.75 6.00

Hamburger Schedule

2.00 1.00 .25 0

The price of hamburgers is $0.25 You would buy 4 @ .25 = $1.00

Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

19-31

Consumer Surplus
Consumer surplus is . . . the difference between what you pay for some good or service and what you would have been willing to pay Price Purchased MU TU
$2.75 1 2 3 4 5 $2.75 2.00 1.00 .25 0 $2.75 4.75 5.75 6.00

Hamburger Schedule

2.00 1.00 .25 0

The price of hamburgers is $0.25 You would buy 4 @ .25 = $1.00 You would have been willing to pay $6.00
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

19-32

Consumer Surplus
Consumer surplus is . . . the difference between what you pay for some good or service and what you would have been willing to pay Price Purchased MU TU
$2.75 1 2 3 4 5 $2.75 2.00 1.00 .25 0 $2.75 4.75 5.75 6.00

Hamburger Schedule

2.00 1.00 .25 0

The price of hamburgers is $0.25 You would buy 4 @ .25 = $1.00 You would have been willing to pay $6.00 Your consumer surplus would be ($6.00 - $1.00) = $5.00
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

19-33

Consumer Surplus
Consumer surplus is . . . the difference between what you pay for some good or service and what you would have been willing to pay Price Purchased MU TU
$2.75 1 2 3 4 5 $2.75 2.00 1.00 .25 0 $2.75 4.75 5.75 6.00

Hamburger Schedule

2.00 1.00 .25 0

Price of Hamburgers is $2.00

Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

19-34

Consumer Surplus
Consumer surplus is . . . the difference between what you pay for some good or service and what you would have been willing to pay Price Purchased MU TU
$2.75 1 2 3 4 5 $2.75 2.00 1.00 .25 0 $2.75 4.75 5.75 6.00

Hamburger Schedule

2.00 1.00 .25 0

Price of Hamburgers is $2.00 You would buy 2 @ 2.00 = $4.00

Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

19-35

Consumer Surplus
Consumer surplus is . . . the difference between what you pay for some good or service and what you would have been willing to pay Price Purchased MU TU
$2.75 1 2 3 4 5 $2.75 2.00 1.00 .25 0 $2.75 4.75 5.75 6.00

Hamburger Schedule

2.00 1.00 .25 0

Price of Hamburgers is $2.00 You would buy 2 @ 2.00 = $4.00 You would have been willing to pay $4.75

Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

19-36

Consumer Surplus
Consumer surplus is . . . the difference between what you pay for some good or service and what you would have been willing to pay
Price Purchased 1 2 3 4 5 MU TU $2.75 $2.75 2.00 1.00 .25 0 $2.75 4.75 5.75 6.00

Hamburger Schedule

2.00 1.00 .25 0

Price of Hamburgers is $2.00 You would buy 2 @ 2.00 = $4.00 You would have been willing to pay $4.75 Your consumer surplus would be ($4.75 - $4.00) = $0.75
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

19-37

Consumer Surplus
The consumer surplus in this graph would be represented by the area to the left of the demand curve (what you would have been willing to pay) and above the price line

3.00 2.00 1.00 0.25 0 D 1 2 3 4 5 6

If the price of hamburger is $0.25, you would have purchased 4. The consumer surplus would be the triangle area above the price line 19-38

Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

Consumer Surplus
The consumer surplus in this graph would be represented by the area to the left of the demand curve (what you would have been willing to pay) and above the price line

3.00 2.00 1.00 0.25 0 D 1 2 3 4 5 6

If the price of hamburger is $2.00, you would have purchased 2. The consumer surplus would be the triangle area above the price line 19-39

Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.